This note discusses the tradeoffs and provides recommendations about the choice of a tick size. The discussion brings to bear the data and evidence from the US markets, specifically the New York Stock Exchange (NYSE).

The tick size plays an important role in the trading process. The two main effects of a tick size are that it (i) creates a floor for the bid-ask spread and (ii) impacts the price-time priority rules of the limit order book.

Research using data from the NYSE has shown that, prior to a decline in the tick size to one cent, the tick size was binding for the large stocks and kept the bid-ask spread higher than it would have otherwise been. This high bid-ask spread, while enhancing the profits of the market makers and liquidity providers, increased the transaction costs for investors, especially the small retail investors. Given that the provision of liquidity was so profitable for market makers, competition amongst markets arose in the form of Payment-for-Order-Flow and Internalization.1 Further the high tick size led to a situation where orders did not necessarily flow to the least cost liquidity suppliers. Regulatory pressure along with competition led to the decline in the tick size on the NYSE.

The optimal tick size represents the trade-off between increased transaction costs due to higher bid-ask spreads and increased incentives to market makers to provide liquidity. Setting too high a tick size increases transaction costs but provides incentives to liquidity suppliers to post limit orders. Also, the number of shares offered would be higher in a regime with a high tick size. This would benefit large traders (institutions) at the expense of retail traders. Setting too low a tick size makes it easier to gain priority in order execution and reduces the incentives for liquidity suppliers to post quotes. However, a lower tick size would benefit retail investors since it would lower the bid-ask spread.

While we understand the trade-offs involved in the search for an optimal tick size, these trade-offs are likely to vary over time and across stocks. Given the dramatic changes taking place in markets due to high frequency trading, the choice of an optimal tick size in a dynamic environment has become even more difficult.

Given that it is hard for regulators to choose the correct tick size, it is recommended that the choice of the tick size be left to the exchanges within a competitive environment. The regulator’s job should be to ensure a level playing field that fosters competition rather than choose the optimal tick size. Instead of mandating a tick size, it would be better for regulators to facilitate easy entry and exit from the business of providing trading platforms and also fostering competition across exchanges in Europe by, for instance, allowing stocks to be traded across different exchanges as is the case in the US. Mandating a single tick size across all European exchanges may stifle competition and lead to higher transaction costs.

This review has been commissioned as part of the UK Government’s Foresight Project, The Future of Computer Trading in Financial Markets. The views expressed do not represent the policy of any Government or organisation.